Spain, a Housing Bubble and Who Knew What

25/04/2012 3:02 AM AEST
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Updated
24/06/2012 7:12 PM AEST

Last week, Princeton University convened a two-day conference on the European crisis (it was the inaugural conference of something called the Julis-Rabinowitz Center for Public Policy and Finance backed by Princeton alum and founder of hedge fund Canyon Partners Mitch Julis). What's not to like for a chance to contemplate catastrophe? The sun, the cherry blossoms and the students were out in force, and the relatively small room was full of economic luminaries, including recent Nobelist Christopher Sims and, as the day-ending keynoter, New York Times-man Paul Krugman.

The subject was relatively technical, but how else would you tackle the European crisis? The emphasis, both in the lectures and the keynote, swung inexorably to Spain, which, as Krugman said, appears increasingly to be the epicenter of what's really a colossal mess. Spain is interesting for many reasons: its size; its massive, U.S.-style real estate bubble and collapse; its almost New Deal-like willingness to try just about anything to wriggle out of its mess, which a number of folks agreed could be either very good or very bad. But Spain does not conform to the conventional wisdom of Greek-style fiscal profligacy that hangs over the crisis. Spain, like Ireland, ran a fiscal surplus. Its problem, which is now eroding its fiscal situation, was a massive, private, credit-driven bubble fueled by the banks, notably the so-called cajas.

There's a lot to say about this construction boom. As Luis Garicano, a professor at the London School of Economics, laid out, the Spanish have an unusually high rate of homeownership. It's a Spanish thing. There's also a lot of open land and a decent transportation sector -- just like, joked Krugman, the American "sand states" of Florida, Arizona, Nevada and California, which were similarly hit hard. As credit poured into Spanish banks and cajas from northern Europe, particularly German banks, it flowed into housing. This went on for any number of years. Construction, which is neither a particularly efficient nor technically advanced industry, was such an overheated sector that Spain saw, unusual in a developed economy, its figures on high school and college dropouts increase alarmingly. The reason: It was too easy to take a decent-paying temporary construction job than study. As a result, despite relatively low unemployment for Spain and the appearance of a boom, the underlying situation, particularly in terms of total factor productivity, was eroding. In short, Spain was becoming less competitive.

Today, Spain famously not only has Great Depression-like 24 percent unemployment, but about 50 percent of youths under the age of 25 without work.

In the U.S., the conventional wisdom about the real estate crisis is that no one in the media or in economics saw it coming. Economists were bought off by Wall Street and captured by free-market ideology. The media didn't pursue enough investigative journalism that would have revealed everything. In both cases, the failure to see what was in front of their noses gets distilled down to conflicts and bad faith. Is all this an exaggeration? Sure. But it's a meme that persists.

What was the situation in Spain? The construction bubble was widely recognized, discussed, worried over and even acted upon in the years before the bust, argued Garicano, a point reinforced by Columbia Business School's Tano Santos, who spoke on the banks. (Krugman, in his lecture, took the tack that no one saw it coming in Spain, or at least problems were denied by the euro crowd, but he offers as evidence one admittedly secondhand anecdote.) Many in and around the Spanish government were alarmed, which helps explain the fiscal surplus; well before the bust, the government was trying to shore up its own reserves and to nudge the banks to greater provisioning. And it wasn't just the housing boom itself -- Garicano estimates there may be as many as 1.5 million empty housing units, and the banks (unlike in the U.S.) resist letting prices fall -- that economists and politicians feared: It was the underlying and chronic productivity and competitiveness woes. But given that the currency, the euro, was not "theirs," meaning it couldn't be devalued to adjust for Spain's mounting balance of payments problems, there was little it could do but hunker down, wait and pray. The result is far worse than most imagined, which is typical of a bubble.

Let's take this who-knew-what issue one step further. On the larger question of the eurozone's embedded contradictions, which now seem as obvious as an elephant in the bathtub, it's quite clear that any number of economists expressed reservations well before the euro was introduced in 1991. Krugman took up this subject, reeling off economic arguments about a single currency's deficiencies in a market with restraints on labor mobility -- folks moving to new jobs being one of the few available means of adjustment in a currency union like the euro zone. But Krugman, with a charitableness not always evident in his Times' column, also moved to defend the larger political ideals of the union, and argued that they swayed those who should have seen this coming. That seems fair. Like so many aspects of the American crisis, it's hard to believe that everything that occurred can be laid upon the altar of greed and self-interest. Certainly they exist, as does ignorance and blindness, and not just among the proverbial "low-information" voter. But some policies were pursued with reasonable, even good intentions, albeit with unfortunate consequences.

The gloomy news here is that, given Europe's political polarization (which also stems from history and culture), no one sees an easy way out. As Garicano eloquently concluded in his talk, solving Spain's housing problem is not that relatively costly, given Europe's resources and Spain's size. It would need an infusion of money, say $100 billion, to allow the banks to allow the housing market to clear. Given that the housing depression is costing Spain several percentage points of economic growth each year, that seems like a relative bargain. But even Garicano admits that it won't be seen that way. After all, the conventional wisdom narrates a story about fiscal profligacy and looming bubbles, for which the leeches of austerity remain the one and only cure.